Four Ways to Help Us Out of the Crisis

This column was written by Michael Kao, CEO and portfolio manager of Akanthos Capital Management, a hedge fund specializing in convertible, capital structure and event-driven arbitrage strategies.

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The catastrophic turn of events in the financial markets this month were actually exacerbated by the Treasury's "fixes" themselves.

From my "front lines" perch as a hedge fund manager that traverses up and down capital structures (loans, bonds, convertibles, preferreds, equities, options, etc.), let me offer four key observations and solutions that the equity-centric media coverage may have missed:

Problem No. 1: The Fannie (FNM - commentary - Cramer's Take)/Freddie (FRE - commentary - Cramer's Take) "bailout" eviscerated the preferred markets.

When Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship, he also eliminated the dividends on $36 billon of preferred stock, and that move sent formerly AA-rated securities to mere cents on the dollar overnight. Treasury's flawed assumption was that the agencies are special entities and that the treatment of their preferred shares ought not to affect the preferred securities of other financials. How utterly wrong and naive.

In the days following the "rescue" of Fannie and Freddie, the market for financial preferreds was essentially eviscerated, virtually eliminating any hope of recapitalization through public markets.

Why is this relevant? Aside from the direct consequences of many regional banks having to write their agency preferred investments to nearly zero and further eroding already-thin capital ratios, the overall market for preferreds is significantly larger than the amount of agency preferred outstanding. In fact, this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised nearly $80 billon during this period from straight and convertible preferred issuance.

It's one thing to "punish" common equity holders who arguably have lived off the "fat of the land" when Fannie and Freddie reaped abnormal profits, but it's entirely another thing to pull the rug out from under a class of investors (senior to the common) who stuck their neck out to recapitalize financial firms in need less than one year ago! This has caused preferred holders to hedge their exposure by heavily shorting the underlying stocks, further blowing out their cost of capital for the underlying companies.

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Michael Kao is the CEO/Portfolio Manager of Akanthos Capital Management, a hedge fund specializing in convertible, capital structure, and event-driven arbitrage strategies. He has devised and implemented investment strategies spanning multiple asset classes and markets since 1992. Prior to forming Akanthos in 2002, Mike worked at Canyon Capital Advisors where he analyzed, devised and implemented trading strategies in convertible and capital structure arbitrage, merger arbitrage, stand-alone and option strategies, and firm-wide portfolio hedges using index options, interest rate instruments, currency options and commodity options. While at Canyon Mike co-founded the firm's arbitrage strategies group and co-founded the Canyon Capital Arbitrage Fund, directing investments for just under $700 million of fund capital in various arbitrage strategies spanning convertible, capital structure and merger arbitrage. Mike began his investment career at the J. Aron Currencies and Commodities division of Goldman, Sachs & Co. engaging in index arbitrage, proprietary trading strategies in over thirty underlying future and options markets, and dynamically hedging and making markets in various commodity-linked derivatives. Mike is a graduate of the University of California at Berkeley (B.S., Electrical Engineering and Computer Science) and the Wharton School of the University of Pennsylvania (M.B.A., Finance).